A very popular benefit offered by employers are Flexible Spending Arrangements (FSAs). The reason why these arrangements are so popular is no mystery. FSAs allow employers and employees to use pretax dollars to pay for certain personal expenses that aren't otherwise covered by insurance.

There are basically two types of FSAs: health care FSAs and dependent care FSAs. As the names imply, the former is for reimbursing health care expenses, including any insurance deductibles and copayments, and the latter is for reimbursing dependent care expenses, such as daycare or sitter fees.

Basically how FSAs work is that employees agree to payroll deductions to put pretax dollars into an account and then use the funds during the year for reimbursement of certain types of expenses. They qualify for federal income, Social Security, and Medicaid tax breaks, plus state income tax breaks in many states.

Example

Your employee, Steve, who earns $32,000 in salary, elects to place $2,000 in a FSA. Income tax, FICA taxes, and FUTA taxes will be paid only on $30,000. The $2,000 in the FSA is not subject to the taxes.

Basic Rules for FSAs

The following are some of the basic rules for FSAs:

An employee must choose how much to put in the account at the beginning of the year (although all of the money does not have to be contributed at the beginning of the year).

The account may not establish a premium payment schedule based on the rate or amount of claims incurred.

The entire amount the employee has elected to contribute for health care expenses (less any amounts previously reimbursed) must be available at all times to reimburse expenses.

Failure to pay premiums, however, will terminate FSA coverage and any claims incurred after the date of termination will not be eligible for reimbursement.

Under the Patient Protection and Affordable Care Act, effective for plan years starting January 1, 2013, the maximum pretax amount that an employee can contribute in a year for a health care FSA is $2,500.

Some FSAs establish a minimum that must be met before a claim will be paid, such as $25 or $50.

If there is a balance left in an individual employee's FSA at the end of the year, generally, it is forfeited after a two-and-a-half month grace period; forfeited funds may be used by the employer to offset future administrative expenses.

Tip

Unused benefits or contributions relating to a particular qualified benefit may only be used to pay or reimburse expenses incurred with respect to that benefit; unused benefits or contributions may not be cashed out or converted to any other benefit. Any benefits remaining unused after this grace period will be forfeited under the use-it-or-lose-it rule.

Under a modification to the use-it-or-lose it rule, beginning in 2013, employers have the option of allowing up to $500 of any amount remaining unused in an FSA as of the end of the plan year to be carried over to the following plan year. The amount carried over may be used to pay or reimburse qualified expenses incurred during the full plan year to which it is carried over. Employers also have the option of amending a plan to provide that an amount lower than $500 is able to be carried over to a subsequent year. The $500 permitted carryover amount does not impact the annual contribution amount.

Warning

It’s important to note that if your FSA plan allows the carryover, it cannot also allow for the two-and-a half month grace period after the year’s end and vice-versa. Only one is permitted. Therefore, if you already have an FSA plan in place with a two-and-a-half month grace period feature, you will have to change your plan to eliminate the grace period if you wish to allow for the carryover option instead.

The plan administrator should allow 90 to 120 days after the end of the year for participants to submit claims.

The plan need only pay claims that are incurred during the plan year; the administrative system you set up must be able to distinguish between claims made in one year for expenses in the previous year and claims made in one year for expenses in that same year.

If someone who participates in the account is entitled to COBRA benefits, and that person elects to continue as an account participant, you would have to continue to honor the claims and accept the payments.

Reimbursable and Nonreimbursable Expenses Under FSAs

There are different types of expenses that can be reimbursed to employees who participate in FSAs.

Expenses that can be reimbursed to employees who participate in a health care FSA:

deductibles or coinsurance not covered by the health insurance plan

expenses for diagnosis, treatment, cure, or prevention of disease, if prescribed by a physician